Investment Strategy

The hidden profit killers

Have you ever thought about all the charges that you pay to financial intermediaries? There are many of them and they can really add up. In the long run, if you don’t control your costs, they can become serial “profit killers”. Identifying winning investments is the exciting side of growing your wealth. But you neglect the cost side at your peril.

The name of the game with investing is to preserve and grow your wealth. Even just preserving it, by which I mean keeping up with inflation, is a challenge. To achieve that you need to beat a combination of price inflation, taxes and investment costs.

There’s nothing you can do to control inflation rates. Simply know that money loses value over time. You just have to deal with the hand that you’re dealt by identifying investments that give inflation protection, such as real estate, stocks (shares) and gold. The current global fraud, where money is being printed in vast amounts, makes this more important than ever.

You can usually manage taxes to some degree. Investing some time and money (advisory fees) in making sure you aren’t paying too much is usually a good idea.

There’s one area that you can definitely control though, or at least contain. That’s the area of your investment costs. These are the fees, commissions and trading spreads that are charged by brokers and fund managers. They can really add up.

I’ve seen first hand how much money this industry makes from its customers.

Remember, I worked in one of the world’s largest investment banks for 15 years. I’ve seen first hand how much money this industry makes from its customers.

If you invest in an investment fund, such as a mutual fund or exchange traded fund (ETF), there are usually annual management fees. These usually fall into a range of 0.5% to 2% a year.

Sometimes there are up front investment fees charged at the time that you first invest in the fund. These could be, say, 1% of the amount invested.

And increasingly there are performance fees. These usually pay a share of the profits to the fund manager, above a certain minimum performance threshold. These could be anything from 2% to 10% of the fund value, depending on profits.

The fund will be held in an account at a broker, along with any direct investments you have in individual shares. The broker will often charge an annual account fee, just to keep your account open. This can be several hundred dollars a year.

Also, most brokers charge a custody fee, which is the fee for looking after your stock and fund investments and processing payments such as dividends received. This is usually 0.5% of the account size, or less.

You also pay each time you buy or sell and individual investment. Let’s call these the trading costs. There are two, and sometimes three, ways that you get charged trading costs.

The first and often the largest of these is the trading commission. This is a percentage of the value of the trade. So if I want to buy $20,000 of shares in company XYZ I may have to pay the broker 0.5% commission, or $100.

You need to check the details of the commission schedule with your individual broker, and find the best deal for your typical trade size. Typically, commissions range from 0.3% to 2% per trade for private investors.

Brokers and investment banks match sellers and buyers in the markets and clip a spread between the prices that they are buying and selling at.

Apart from commissions there are “spreads”. At any given time the price you can buy a share for and the price you can sell it at are different. Brokers and investment banks match sellers and buyers in the markets and clip a spread between the prices that they are buying and selling at.

This is called the “bid-offer spread” (or “bid-ask spread”). You can buy at the higher offer price and sell at the lower bid price. The size of the spread varies massively depending on the share being traded.

Large companies with high share trading volumes usually have tiny spreads. At the time of writing the bid-offer spread on Coca-Cola stock was less than 0.03%. But for smaller companies, with little trading volume, the spreads can run to several percentage points. This is often the case in emerging or frontier markets.

Even if you buy a share today and don’t sell it for many years, you will still pay the spread along the way.

The final part of the trading costs come from currency transactions when you are investing internationally. Say you have cash deposits held in US dollars but want to buy a share that trades in Indonesia in rupiah, the local currency.

First the cash has to be converted from dollars to rupiah before you can buy the shares. The broker will charge you a spread to do the currency transaction, on top of the bid-offer spread already baked into the share price. Plus the broker’s commission, of course.

Adding up all the fees, commissions and spreads you can easily end up paying away to your broker several percent of your account value each year. It depends on how often you trade, what you invest in and the broker you use. But a typical range is anything from 1% to 5%.

If your account size is $100,000 that means it is costing you between $1,000 and $5,000 a year. Over 10 years that’s $10,000 to $50,000, which is significant money.

Bloomberg recently ran a story about the fees in managed futures funds. These are a specialist area of hedge funds, popular in the USA, that trade financial or commodity futures, a type of derivative.

 …investors have only kept $1 out of every $10 of profit made, despite taking all the risk.

They cite studies that show that for this type of fund, on average, 89% of fund gains have been paid away to the fund managers as fees or other charges. In other words, investors have only kept $1 out of every $10 of profit made, despite taking all the risk.

These kind of high fee funds are something that you must avoid, unless you like making fund managers rich. However exciting the sales pitch sounds, if the fees are high then you are extremely unlikely to do well.

Controlling the profit killers

Over your investing life, getting a grip on costs can make a big difference. This is due to the power of compounding, which is covered in chapter 2 of the Wealth Workout: five essential steps to investment success, which you can download here.

(If you’re reading this on the website, and haven’t signed up yet to this free service, I encourage you to click here to get some of the best, most potentially profitable ideas from the top investing minds in the business.)

When it comes to costs, compounding works against you. Higher costs kill long term profits as they pile up on each other.

When it comes to costs, compounding works against you. Higher costs kill long term profits as they pile up on each other. If you cut your average costs by just 1% a year, as a percentage of the amount you have invested, that can really add up over time.

After 10 years saving just 1% a year makes you 10.6% better off. Over 20 years it’s 22.3% and over 30 years it’s 35.2% more money to your name. Since most people invest over many decades you can see that cost control makes a big difference to the final outcome.

If you manage to reduce costs by 2% a year then the outcome is even more dramatic. Over 10 years you’re 22.4% better off. After 20 years you’re 49.8% better off. That’s half as much more money as if you’d just carried on paying huge fees. And over 30 years you’ll have 83.3% more wealth than if your costs had been out of control.

So don’t forget OfWealthers, it’s important to pay attention to your investment costs if you want to look after your wealth. Part of this will depend on the level of service you want. But for any given level of service there is no point paying more than you need to.

I recommend you take steps today to review how much you are paying and whether you can get a better deal. Make sure you’re not leaving yourself at the mercy of the hidden profit killers.

We all need brokers and fund managers when we’re making our financial investments. But that doesn’t mean we need to overpay them for their services.

Stay tuned OfWealthers,

Rob Marstrand
robmarstrand@ofwealth.com

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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.